Loco Hong Kong Holdings (HKG:8162) Shareholders Should Be Cautious Despite Solid Earnings

Solid profit numbers didn't seem to be enough to please Loco Hong Kong Holdings Limited's (HKG:8162) shareholders. Our analysis has found some concerning factors which weaken the profit's foundation.

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A Closer Look At Loco Hong Kong Holdings' Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. While it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Loco Hong Kong Holdings has an accrual ratio of 0.44 for the year to December 2024. That means it didn't generate anywhere near enough free cash flow to match its profit. As a general rule, that bodes poorly for future profitability. In fact, it had free cash flow of HK$5.4m in the last year, which was a lot less than its statutory profit of HK$32.1m. We note, however, that Loco Hong Kong Holdings grew its free cash flow over the last year. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Loco Hong Kong Holdings.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. Loco Hong Kong Holdings expanded the number of shares on issue by 20% over the last year. That means its earnings are split among a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. You can see a chart of Loco Hong Kong Holdings' EPS by clicking here.

A Look At The Impact Of Loco Hong Kong Holdings' Dilution On Its Earnings Per Share (EPS)

Three years ago, Loco Hong Kong Holdings lost money. On the bright side, in the last twelve months it grew profit by 85%. On the other hand, earnings per share are only up 85% over the same period. So you can see that the dilution has had a bit of an impact on shareholders.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So Loco Hong Kong Holdings shareholders will want to see that EPS figure continue to increase. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

Our Take On Loco Hong Kong Holdings' Profit Performance

As it turns out, Loco Hong Kong Holdings couldn't match its profit with cashflow and its dilution means that earnings per share growth is lagging net income growth. For the reasons mentioned above, we think that a perfunctory glance at Loco Hong Kong Holdings' statutory profits might make it look better than it really is on an underlying level. If you'd like to know more about Loco Hong Kong Holdings as a business, it's important to be aware of any risks it's facing. To help with this, we've discovered 3 warning signs (1 can't be ignored!) that you ought to be aware of before buying any shares in Loco Hong Kong Holdings.

Our examination of Loco Hong Kong Holdings has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. But there is always more to discover if you are capable of focussing your mind on minutiae. Some people consider a high return on equity to be a good sign of a quality business. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks with significant insider holdings to be useful.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.